Wednesday, February 11, 2009

Lately I have been fielding a large number of questions about historical volatility, implied volatility and a variety of related subjects. For this reason, it seems like a good time to kick off what I envision as a series of educational posts on the subject.

First I would like to start out with my own definition of volatility and then throw out some thought starters.

Definition: Volatility is a measure of the degree of change in the price of a security

There are a number of ways to think about changes in the price of a security. For instance, changes in price may be described in terms of:

magnitude (amplitude) – how far?

frequency – how often?

duration – how long?

trend – unidirectional or choppy?

direction – up or down?

In terms of measurement, common ways to measure price changes include:

For the record I have added an "educational" tag to this posts and to the five posts that appear in the "VIX - Educational Posts" section of the blog in the right hand column. I have also decided to unveil a new "volatility" tage that I will try to use sparingly, but should incorporate this series in full.

As an aside, I always like to get input from those who have an interest in epistemology.

What you're getting at is that therm structure of volatility for american options does not work properly. There are lots of different combinations of price movements that could cause implied volatility to match realized volatility but different patterns of realized price movements have different effects on implied volatility even when they represent the same realized volatility. For example when the market when up 10% in one day in October the VIX went.... down.

Tough crowd! I hear what you are saying. What I intended to convey is that with the same daily price move you can get different results when calculating the volatility of that move if the move is measured in points, percentage terms or standard deviations.

Yes measuring the volatility of standard deviations is volatility of volatility, but they can be calculated sequentially. Frankly, it was Jeff Augen's book that got me thinking more about daily standard deviations.

Leo,

That is a very interesting question. I had not thought about using an indicator as the underlying in terms of analyzing volatility, but since the TRIN is one of my favorites, maybe I should take a look at it.

[Unfortunately my one man R&D department is swamped with projects and should be writing a book right now...]

This is not exactly to do with this post but I thought it was closer to this education subject rather than your latest post as I write (which is about Regional Banks).

Yesterday (February 12th) the US markets shot up quite dramatically just before the close. I noticed that the VIX dropped steeply at the same time.

However, when I came to look at the daily moves (close vs close) the S&P500 was only up 0.2% on the day while the VIX was down over 7% I think. Although not totally unprecedented that was quite a striking ratio.

Do you think that 'last minute' action and excitement in the market can give a 'biased' or exaggerated or overly emotion affected result to the closing Implied Volatility number?

Not sure if this is vitally important as I'm sure that things even out over time but I did wonder.

To answer your question first, I do believe that the action in the VIX going into the close has a tendency to be exaggerated during sharp market moves, particularly when the broad market indices are falling rapidly.

While various types of portfolio protection can be purchased around the clock, those looking to buy put protection via SPX puts have until the close of index options trading (4:15 p.m. ET) to do so -- at least in the most liquid market environment.

In my opinion, anyone who postpones buying put protection until the end of the day "to see how bad things get" is likely to be less price sensitive just before the close and be more concerned about filling an order than getting it at the best possible price -- or not at all.

Regarding yesterday's VIX, it was strangely unfearful, particularly during 12:30 - 1:15 p.m. ET, when the SPX sold off fairly substantially, while the VIX hardly moved.

Purpose of this Blog

The intent of this blog is to educate, inform and entertain readers, while also serving as an archived learning laboratory of sorts as I try to sharpen my thinking in areas such as volatility, market sentiment, and technical analysis. I also enjoy charging off on tangents and hope that readers may find some illumination or at least amusement in these forays.

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About Me

Chief Investment Officer at Luby Asset Management LLC in Tiburon, California. Previously worked as a full-time trader/investor and also a business strategy consultant. Education includes a BA from Stanford and an MBA from Carnegie Mellon.
Useless trivia: I once broke the world pogo stick jumping record without knowing it.